Don Warrant, CPA, Director and Tim Dalton, CPA
Trust Residency Rules: Supreme Court Limits State Ability to Tax Trust Income
The U.S. Supreme Court has ruled against a North Carolina law that attempted to collect income tax from a trust based solely on the residence of a beneficiary. The court held that North Carolina’s attempt to tax undistributed trust income based only on the fact that a beneficiary lived within its borders violated the Due Process Clause of the Fourteenth Amendment because the state “lacks the minimum connection with the object of its tax that the Constitution requires” (North Carolina Department of Revenue v. Kimberly Kaestner 1992 Family Trust).
Using Trusts to Manage Wealth Transfers - Good News about Trust Residency Rules and a Helpful Reminder
The ruling may provide some comfort for taxpayers who use (or are considering using) trusts to manage wealth transfers, as it does find that the state’s attempt to tax the trust’s income was an overreach in this instance.
However, the most important takeaway for grantors, trustees, beneficiaries and administrators is an understanding that the impact of state tax laws must be considered not only at the creation of the trust but throughout its administrative life. If your financial plan includes a trust, it should also include regularly scheduled update meetings with the advisors who administer it.
Unusual Circumstances for Kaestner Beneficiaries
States can impose income taxes on trusts based on a variety of different connections with the jurisdiction. A trust could be liable for tax in a state based on any or all of the following factors:
- Location of administrative functions.
- Residence of grantor.
- Residence of trustees.
- Residence of beneficiaries.
- Did not receive any distributions from the trust,
- Had no right to demand or receive any distribution from the trust, and
- Were not certain that they would ever receive a distribution from the trust.
If any of those criteria had not been met, the court may have ruled differently.
The Kaestner opinion does limit a state's ability to tax undistributed trust income based on the residence of a beneficiary. But the court didn't rule that the North Carolina law was unconstitutional. The justices agreed only that North Carolina couldn't tax undistributed income from this trust based on these facts. The circumstances of this case are such that other trusts might with not win a similar challenge.
Freed Maxick Offers Residency Reviews for Trusts
The Kaestner ruling points out the importance of state residency considerations when planning and managing a trust. Individuals with existing trusts should consider reviewing the residency of beneficiaries to determine if a state income tax may have been overlooked or if a state tax refund may be in order.
Those who are planning to manage an asset transfer using a trust in the future need to incorporate state tax rules into their planning and build in a process for updating administrators on any changes in residence of beneficiaries.
For more information on how the Supreme Court’s Kaestner opinion could affect your current or future trust plans, please contact the trust planning professionals at Freed Maxick by clicking on the button, or call me at (716) 847-2651.